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Is China’s Shadow Banking Sector A Legitimate Form of Finance Now?

Apr 04, 2019
  • Sara Hsu

    Visiting Scholar at Fudan University

February’s credit data was unexpectedly low, with financial institutions extending 885.8 billion yuan in RMB loans, down from the record 3.23 trillion yuan reached in January. Off-balance sheet lending declined by RMB 364.8 billion. These indicators were below analyst expectations, and are yet another sign of China’s slowing economy. At the same time, the data reveal officials’ struggle with dampening financial risks while ensuring sufficient liquidity in the economy. As a result, it is no surprise that some government officials have considered some forms of shadow banking to be, if not attractive, at least acceptable in a climate of financial prudence.

As long as it benefits the real economy, it’s fine

Wang Zhaoxing, vice-chairman of the China Banking and Insurance Regulatory Commission (CBIRC), stated on the sidelines of the National People’s Congress that for shadow banking institutions, “whose financing benefits the real economy and which have good internal risk controls, we may continue to allow them to exist and support them.”  He went on to state that the CBIRC has asked commercial banks to offer loans to small and micro businesses and to contain risks.

The deleveraging and derisking campaign that sought to reduce lending to overcapacity industries and dampen risks in the shadow banking industry restricted lending to private firms, and these companies are in need of funding. Approved channels of shadow banking can help to reduce the credit crunch in the private arena.

Is it fine?

This brings forward the question of whether elements of China’s shadow banking sector can be legitimized as being viable components of the financial system. At the moment, there are no clear areas of shadow banking that should be fully brought into the light, although some subsectors are less risky than others. Let’s look at the biggest components of shadow banking: asset management products, including wealth management products; trust loans; entrusted loans; and internet finance.

Asset management products, including wealth management products, have faced much stricter regulations in the past year. Of the new regulations, the rules requiring removal of implicit guarantees may be the most impactful, as many retail consumers have viewed that such products are riskless. In addition, large Chinese commercial banks are set to create separate wealth management subsidiaries, in response to rules that require lenders to separate wealth management units from parent banks. This latter rule, in addition to the onslaught of requirements aimed at reining in risk among asset management products, may serve to bring wealth management products into the light, although such products have a tendency to move toward high risk, high-return underlying assets.

Although the trust industry claims to be one of the four pillars of the financial industry, trust loans, in the past, have been extended to risky borrowers. The industry has been through regulation, which has touched the asset management industry as well as banks’ off-balance sheet business.  The trust industry itself has received several regulatory reckonings. Trust companies were urged to move from high-speed growth to high-quality development, and firms were examined by regulatory authorities. This has helped reduce risks in the industry. Notably, most trust companies, at present, are passive managers of their products, and real estate investment is rising somewhat, bringing along with it associated risks.  However, most trust products are invested in industrial and commercial enterprises, and to a lesser extent in financial institutions, basic industries, and securities markets, which indicates that they are rooted to some extent in the real economy. Therefore, the trust industry, although complex and somewhat opaque, may be an area that officials can legitimize and rely upon more strongly.

Entrusted loans have been regulated to reduce the role of commercial banks in transactions and to prevent investment in bonds, derivatives, or asset management products. Commercial banks must also improve risk management for entrusted loans. As a result of these regulations, entrusted loans have declined through 2018 and 2019.

Internet finance, particularly peer-to-peer (P2P) lending, was fraught with risks until the government stepped in last year and required the lending platforms to be information intermediaries only. The industry went into fast decline, and there were rumors that the government would do away with the sector altogether. The biggest risk with regard to P2P lending companies was credit risk, as many smaller firms lacked the capacity to sufficiently ensure that borrowers were good credit bets. Cases of fraud among P2P lenders who were engaging in Ponzi schemes also emerged, damaging the reputation of the industry. This area of shadow banking has a very poor outlook and its survival is not guaranteed.

Trust the trust industry?

Of the major shadow banking sectors, the trust industry appears to be the most suited for endorsement, and the other sectors do not. Asset management products, entrusted loans, and internet finance are still pretty risky. While they do provide funds to businesses that would otherwise not be able to obtain them, and returns to investors who have few viable alternatives, these areas are prone to risks solely due to their nature. For example, in the case of entrusted loans, in which businesses lend to other businesses, the ease of investing in risky ventures remains problematic. In the case of P2P lending companies, the lure of setting up a platform without providing sufficient credit checks is pretty strong. Finally, in the case of asset management, especially wealth management, products, major precedent has been set in the past eight years or so to create attractive returns based on opaque and super risky underlying assets.

While the trust industry is not perfect by any means, it does serve the real economy to some extent. This sector also has regulatory support behind it. The China Banking and Insurance Regulatory Commission stated in 2018 that, “trust companies to transform from high-speed growth to high-quality development and to vigorously support the development of the real economy." The CBIRC has stepped up monitoring and policy guidance of the sector.

So, while shadow banking on the whole remains too risky to fully legitimize as a reliable form of finance for China’s economy, there is one aspect that, under strong supervision, may provide a pressure valve for financing needs that banks cannot fully satisfy. Trust companies may prove to be worthy of regulators’ efforts to improve their practices. As we have seen, however, this not guaranteed.

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